INVESTORS JITTERY OVER NEAR COLLAPSE OF HEDGE FUNDS

The near collapse of two hedge funds owned by the Bear Stearns investment bank has left not only Wall Street jittery but also public pension fund managers and millions of small investors across America.
On June 21, Bear Stearns moved quickly to stop the hemorrhaging of the funds by shoring them up with over $1.6 billion but the future for both funds remains uncertain and the crisis raises serious questions about what is a virtually unregulated part of the financial markers. The funds in question were within the bank’s High-Grade Structured Credit Strategies Fund and were dealing in CDO’s – collateralized debt obligations. Essentially CDO’s are mortgage debits matched with other debts and are bought up by investors on the basis that over time as those debts are paid off at high interest rates they will produce big profits. But the Stearns’ funds were operating against a backdrop of a changing housing/mortgage market. Mortgage debt across America had led to unprecedented numbers of foreclosures because too many lending companies had given loans to risky borrowers. The result was that CDO’s in the debt market began to suffer potentially big losses. The Bear Stearns Funds had raised over $1.5 billion from investors but were gambling on over $30 billion in debt securities. In April the two funds saw a drop of 23% in their value, making it clear that the boom days for bonds supported by homeowners with weak or subprime credit were coming to an end. The market could no longer sustain a situation in which many people were being given mortgages to buy homes at $450,000 with little or no collateral. Homeowners were falling behind on loan repayments and foreclosures were growing at an alarming rate. Some analysts are now forecasting that Bear Stearns may spend over $3 billion to protect the future of the strongest of its two fund and ignore the weaker, which lost half its value.
A major concern on Wall Street and among investors is that the hemorrhaging, even of the more robust of the two funds, may have been stopped only temporarily, and in the not too distant future it will collapse and bring down a large slice of the market by creating even more investor nervousness about hedge funds.
Hedge funds are almost unregulated and have a unique role within the financial markets in the US. They are permitted to operate at a high level of secrecy and, unlike pension funds, mutual funds and funds from insurance companies, they are not obligated to release information to the public about their activities. At the beginning of the 1990s, there were approximately 600 hedge funds with a total asset value of $39 billion. The number of funds has since ballooned to 8,000 with assets well over $1 trillion. The massive increase was due to the fact that their often high yields attracted public pension funds, corporate groups of wealthy investors and in recent years millions of ordinary Americans encouraged by the Bush Administration to gamble on the markets.
By the start of 2007, public pension funds spent about one tenth of their assets in hedge funds and private equity funds. Much more was invested in hedge funds by charities and endowments. The ordinary investor was quick to see that unlike mutual funds, hedge funds annually performed much better. In many respects greed on the part of ordinary investors prevented them from seeing that greater risks could mean great losses in a collapse.
Members of Congress and regulators have frequently called for greater scrutiny and control of hedge funds but Wall Street has vehemently resisted change. However, if hedge funds begin to slide in the coming year and investors start to panic even Wall Street may drop its opposition to SEC regulation of the funds. Some analysts believe if that happened it might be easier to weed out the risky funds that pose a serious problem to 401Ks.
One of the effects of the Bear Stearns’ crisis is that it will now be exceedingly difficult for banks to package mortgage loans as securities that can be traded by hedge funds. In a housing market that is seeing the downward impact of the overblown tendency to give large mortgages to risky borrowers the chances are that things can only get worse. Until the risky trading practices of hedge funds are exposed and the veil of secrecy surrounding their activities is lifted, those who gamble with hedge funds should realize the risks may not be worth the potential losses in a future collapse.